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Reality Time For Dot Coms And The Fed

May 07, 2000

Editorials

Reality Time for Dot-Coms--and the Fed

Incubators are not for babies; VCs are not Viet Cong; and angels don't sport wings--at least not in today's world of Internet finance. Instead, these groups make up a new financing phenomenon that, in the past three years, has pumped billions of dollars into spanking-new Net startups. The sharp April downturn in the prices of high-tech stocks, sparked in part by higher interest rates, is now causing these financiers to pull back sharply. Many startups are gasping for lack of funds. To those who are worried about speculative "froth" in the markets, this is all to the good.

But there is a danger in the financiers' pullback. The thousands of new Net companies generate enormous competition in the economy and tend to keep prices low. The Federal Reserve is facing an unprecedented dilemma as the evolution of the New Economy proceeds. Higher interest rates are clearly needed to combat creeping cyclical inflation. But as evidence of rising prices accumulates, there is the danger that inflation hawks at the Fed will demand drastic action. That would be a mistake. A too-tight monetary policy could choke off financing for new Internet companies and actually make inflation worse over the long run.

While technology gets most of the credit for the Internet revolution, the role of venture capital is probably just as important. It is precisely the coincidence of new technology and low-cost entry for startup companies that is making the fast growth of the New Economy possible. The venture-capital industry is composed of thousands of rich individual "angels," traditional venture-capital firms, and new incubators--commercial institutions that nurture Net newborns by providing not only money in the early stages but also legal advice, managers, and even desks and chairs. More than 100 incubators have been formed in the past year alone. Idealab!, one of the oldest such companies, has General Electric Co. Chairman John F. Welch Jr. on its board and just filed for an IPO of its own.

Many dot-coms probably shouldn't have received such generous financing in the first place. Lack of any prospect of profitability and weak management doomed dozens of startups from the outset. It was easy to be a hot venture capitalist back when money was virtually free. Higher interest rates certainly make for more sober VCs. But if monetary policy gets too tight, the expansion of the New Economy could erode and, with it, the very competitive forces that keep inflation in check. It would be sad indeed if the Fed succeeded in stopping cyclical inflation only to harm the deeper disinflationary forces inherent in the New Economy.